17.1 – Commodity options, finally!

My first commodity trade was on pepper futures and this was sometime towards the end of 2005 or early 2006. Since then I’ve closely tracked the developments of the commodities market and the commodities exchanges in India. MCX has done a tremendous job in promoting commodities market in India. They have continuously introduced new contracts and enhanced the market depth. Liquidity too has improved many fold since then. If I remember right, sometime around 2009, there was an attempt to introduce options in the commodity market. Needless to say, when I first heard about this, I was quite excited thinking about all the possibilities that one would have trading commodity options.

But unfortunately, this never came through and the commodities options were never introduced in the market. Since then, this topic on commodities options has surfaced couple of times but each time, it just remained a market rumor.

However, it now appears that options on commodities will finally hit the market sometime soon. Around June 2017, SEBI cleared the files to permit commodities options.

Since then commodities exchanges have been working hard to build a good framework to introduce the commodities options. Given this, I thought it would be good to have this quick note on what to expect and what to look for in the commodities options market.

For those who are not too familiar about options, I’d suggest you start reading the module on Options here.

Just like futures, the options theory for commodities would remain the same. You have to just pay attention to logistics, and that’s the objective of this chapter.

17.2 – Black 76

One of the important bits that you need to note with commodity options is that these are options on Futures and not really the spot market.

For example, if you look at a call option on Biocon, the underlying for this option is the spot price of Biocon. Likewise, if you look at Nifty options, the underlying is the spot Nifty 50 index value. However, if you were to look at an option on Crude Oil, the underlying here is not the spot price of Crude Oil. This is quite intuitive as we do not have a spot market for Crude Oil or for that matter any commodities in India. However, we do have a vibrant futures market. Hence the commodity options are based on the commodity futures market.

If one were to talk about the crude oil options, then you need to remember the following –

The underlying for Crude oil option is Crude oil Futures

The underlying for crude oil futures is the price of Crude Oil on NYMEX

So in a sense, this can be considered a derivative on a derivative. For all practical purpose, this should not really matter to you while trading. The only technical difference between an regular option (with spot as underlying) and option on futures is the way in which the premium is calculate. For the former, the premium can be calculated by using a regular Black & Scholes model and for the latter a model called Black 76 is used.

The difference between these two models is the way in which the continuous compounded risk-free rate is treated. I will not get into the details at this point. But do remember this – there are plenty of Black & Scholes calculators online, so don’t be in a hurry to punch in the commodities variables in a standard B&S calculator to extract the premium value and Greeks. It simply won’t work ☺

17.3 – Contract Specifications

We still do not know how the exchanges will set up the framework for these options. However, we did take a look at the mock framework and I’m guessing it won’t be too different from that.

To begin with, exchanges may roll out Gold options, and would slowly but for surely introduce options on other commodities. Here are the highlight.

Option Type – Call and Puts

Lot size – Since these are options on futures, the lot size will be similar to the futures lot size

Order Types – All order types would be permitted (IOC, SL, SLM, GTC, Regular, Limit)

Exercise style – Options are likely to be European in nature

Margins – SPAN + Exposure margin applicable for option writing and full premium to be paid for option buying. A concept of devilment margin will come into play, I’ve discussed this towards the end

Last trading day (for Gold) – 3 days prior to the last tender day

Strikes – Considering one ‘At the money strike’ (ATM), there would be 15 strikes above and 15 strikes below ATM, taking the total to 31 strikes.

This is where it gets a little tricky. Equity option traders are used to the following ‘Option Moneyness’ convention –

At the Money (ATM) Options = This is when the spot is in and around the strike. So in a given series, only 1 strike is considered ATM

In the Money (ITM) = All call option strike below the ATM and all put option strikes above the ATM are considered ITM options

Out of the Money (OTM) = All call option strike above the ATM and all put option strikes below the ATM are considered Out of the Money (OTM) options

However, the commodities options will introduce us to a new terminology – ‘Close to Money’ (CTM) and this is how it will work –

ATM – The strikes closest to the settlement price is considered ATM

CTM – Two strikes above and two strikes below ATM are considered CTM

OTM and ITM – The definition remains the same as in Equity.

Settlement – For daily M2M settlement in Futures, the exchange considers the commodities daily settlement price (DSP) as the reference value. The DSP of the commodity on the expiry day will therefore be the reference value for the options series as well.

Let’s quickly understand how the settlement works. Consider this example – Assume the DSP of a commodity is 100. Assume this commodity has a strike interval at every 10 points. Given this, let’s identify the moneyness of strikes –

ATM = 100

CTM = 80, 90, 100, 110, and 120. Note, we have included two strikes above and below ATM

OTM = All Call option above 100 and all Put options below 100 are considered OTM and therefore worthless

ITM = All Call options below 100 (including 80 and 90, which are CTM) are ITM, and all Put options above 100 (including 110 and 120, which are CTM) are ITM.

All long option holders which are ‘CTM’, will have to give something called as an ‘explicit instruction’. An explicit instruction will devolve the option into a futures contract. The futures contract will be at the strike. For example if I hold 80 call option, then upon an ‘explicit instruction’, the call option will be devolved into a long futures position at 80. I’m guessing the ‘explicit instruction’, will be tendered via the trading terminal.

Now, here is an important thing that you need to remember – If you do not give an explicit instruction to devolve your CTM option, then the option will be deemed worthless.

All ITM option, except CTM, will get automatically settled. You need to be aware that settlement in options market is by means of devolving the option into an equivalent futures position. If you are holding a non-CTM, ITM option and you wish not to settle this automatically, then you need to give a ‘Contrary instruction’. In the absence of which, the contract will be automatically settled by means of devolvement.

Now, the question is why would you not want to exercise an ITM option?

There could be an instance where the ITM option that you have may not be worth exercising given the taxation and other applicable charges. So in this case, you are better off not exercising your ITM option rather than exercising it. So, this is when you use the ‘Contrary instruction’, privilege and opt not to exercise your ITM option.

17.4 – Devolvement into Futures contract

So assume you have an ITM (including CTM) option, and upon expiry the option will be converted (or devolved) into a Futures position. Now, we all know that a futures position requires margins to be parked with the broker. How do we account for this? I mean, when I go long on option, I just have to pay for the premium right? Naturally, at the time of buying the option, I would not park additional margin anticipating that the option ‘might’ get devolved into a futures position.

To circumvent this, there is a concept of ‘Devolvement Margin’. I will cut through the technicalities and let you know what you should know and expect –

Commodity options will expire few days before the first tender date of the futures contract. This means, there will be few days gap between the expiry of the futures contract and the options contract

Few days before the options can expire, exchanges will conduct a ‘What if scenario’ and generates a ‘Sensitivity Report’ to identify strikes which are likely to be ITM and CTM

For all such options, exchanges will start assigning ‘Devolvement Margin’, this means you will have to fund your account with enough margin money to carry forward the option position. Half of the required margin needs to be available a day before the expiry and the remaining half on the day of expiry of the options contract to convert the position to a futures contract.
For example, The Expiry of the Gold option contract is on 28 November 2017 and the futures contract expires on 5 December 2017. Half of the margin needs to be added to the account on 27 November and the remaining on 28 November

If you holding a deep ITM option, then the profits arising out of this position will be considered to offset a portion of the margins required

Given the above point, the deeper the option, lesser would be the margin required. This also means CTM options will attract higher margins

In simpler words, if you are holding a commodity option, and it’s likely to expire ITM, and you intend to carry to expiry, then you need ensure you bring in margin money as you approach expiry

How much margin, expiry dates, tender date etc will vary based on the commodity

Here is a quick note on how the options position will be devolved.

Option Position

Devolved into

Long Call

Long Futures

Short Call

Short Futures

Long Put

Short Futures

Short Put

Long Futures.

I guess as and when the option contracts roll out, we will have greater insight into the structure. I will updated this chapter when the commodity options roll out with the exact information.

Stay tuned.

Key takeaways from this chapter

Options on commodities will be on Futures as underlying

One cannot use the regular Black & Scholes Calculator for identifying the premium and Greeks

Black 76 is the model used for Options on futures

Upon exercising the option devolves into a futures position

CTM options are two strikes above and below ATM

If a CTM option holder does not give an explicit instruction, then the option is deemed worthless

An ITM option holder can give a ‘contrary instruction’, to choose not to exercise the option. You would opt for this if you know that the position is not going to be profitable owing to taxes and applicable charges

I have been waiting for this for many years because I know the huge opportunity for making fortune in short commodity future’s options, as the premium would be fat. I have the following questions though:
1. If I am short call/put options, can I square off the position anytime I want to or I have to wait for Expiry day (Because of european style options). If no then that means we have to carry losses without having an option to square off. That will be disastrous situataion.
2. Is it possible to square off short options in cash always as I don’t want my short options to be devolved into futures.
3. What will be likelihood of the options been rigged off in the beginning? I am scared may be some big players take us for a ride perticularly in the commencement months.
4. Do we have to open commodity account with Zerodha to trade commodity options.

1) You can square off anytime, no need to wait till expiry
2) Its best if you square off the position before the tender date and cash out
3) Exchanges work on robust framework, this is unlikely to happen
4) Yes, this is if you wish to trade through Zerodha.

Thank you Karthik!!!
Then why is it european style options. They both can be squared off any time. What do they mean that european style options can only be exercized on expiry? Does that mean that ITM options of buyers can not be squared off before expiry? or it means that only cash square off of ITM options are allowed and not devolvement of ITM options before expiry, I think the latter is most likely answer to my own question.
I am familiar with the equity options of NSE for a long time. And I am very comfortable with them. Now this beast comes up for which I am desparately waiting since announcement 2 years back. Almost daily I search for commodity option start date. But now it seems its nearby.
Apart from the commodity options, there was a news about 6 months back about commencement of Cross currency futures and options. But now it seems they are out of the basket of hope.

Hi Sir,
I read module many times but not able to understand completely,
But I think if you please explain in terms of Nifty I would understand better
I usually trade in nifty and banknifty options only
Let nifty spot is 10006 and nifty future is at 10020
I short call option [email protected]
On expiry nifty is at 9900
I would get 75*50,
If we imagine the above scenario to be traded just like what you explained, what I would get premium or future contract
Please explain
Thanks

It was announced that the Gold options would start somewhere between 6th and 12th October. But it’s almost 10 October and there is no announcement yet?
Any news or idea if they are launching GOLD OPTIONS before Diwali or not?

But I think sebi has allow because I saw this on mcx’s wevsite Circular no.: MCX/MEM/386/2017 October 13, 2017
_________________________________________________________________________
Sub: Waiver of Admission/Transfer Fees – Integration of Broking Activities
Members of the Exchange are hereby notified that in order to encourage existing Members
of MCX/ Members of Equity Exchanges (duly registered with SEBI) to avail the facility of
Integration of Broking Activities, a waiver has been granted in Admission Fees/Transfer
Fees. Accordingly, the following amendments are made in the Business Rules of the
Exchange by inserting Business Rules 11.1 and 11.2 in Chapter 1 of the Business Rules of
the Exchange:
11.1 No Admission Fees/Transfer Fees shall be charged to the existing Members of
MCX/ Members of Equity Exchanges (duly registered with SEBI) applying for
new membership or transfers of membership through
amalgamation/merger/transfer, up to September 30, 2018, provided the
documentation and other processes are complete by the said date.
11.2 The waiver has been made applicable to Applications received after July 13,
2017 (i.e. the date on which SEBI allowed integration of Broking Activities).
The above amendment in Chapter 1 of the Business Rules of the Exchange shall come into
force with effect from the date of this circular.
Members are requested to take note of the same and ensure compliance.
Vandana Vania
Sr. Manager – Membership
Kindly contact Membership Team on 022 – 6649 4080 or send an email at[email protected] for further clarification.
——————————————————- Corporate office ——————————————–
Multi Commodity Exchange of India Limited
Exchange Square, CTS No. 255, Suren Road, Chakala, Andheri (East), Mumbai – 400 093
Tel.: 022 – 6649 4000 Fax: 022 – 6649 4151 CIN: L51909MH2002PLC135594http://www.mcxindia.com email: [email protected]

Logically it should be DSP of the Option’s expiry day and not the future’s expiry day. Suppose gold’s DSP is 30050 then the 30000 CE of Gold should be 50 Rs ITM. and 30100 strike CE should expire worthless as OTM.

Looking at the handouts at mcxindia, Option contract will devolve into a futures position as if taken at the strike price of the Option contract.
Ex:One Call option of strike 29600 bought at 250Rs will devolve into a future position as if bought at 29600. You wud hv 3 days to close/rollover the future position.

I can’t see Gold options in Pi yet. Why is it not updated as the trading in Gold options is starting in 30 minutes @10am. and at 9:30 Zerodha (Kite and Pi) is not ready to offer this product. I was hoping that it will get updated in the securities master of Pi well in advance.

When I clicked on your above link I got a message that my commodity account is not enabled. I used to trade in commodity some months back. How come it’s not enabled. And what is the procedure to enable it?

Oh no!!!
That time I logged in with my brother’s account details whose commodity account is not activated. I realized it later and then I logged in with my account and so….I could give consent easily then….wooooooos

To sell options, you don’t need premium, you will need margins. Margins are dependent on the strike that you choose, but generally, it is about the same as the margin required for a futures trade. Check this – https://zerodha.com/margin-calculator/SPAN/

I have already given consent. I can see the contracts on both kite and pi. I have also contacted support. They say that zerodha has not activated crudeoil options which is hard to believe since I see that there is trading happening.

Please mention whether we have to square off put option position say 5 days before expiry otherwise it will be Physical delivery.
Because yesterday I received an email to square off my position but I wanted to keep that. This question is for contract which has physical delivery obligation. Also mention about other commodities settlement procedure.

Sir I want to know the exact rule. Since I called Zerodha call & Trade they told me to square off position before 11 pm otherwise settlement issue, I did. But I am not sure why he asked me to close ? Please mention exact rule. Want to leave my position in expiry let exchange settle, Ready to pay STT.

Santosh, we do not allow physical delivery of the contract due to operational limitations(Higher margin requirements, etc).
Therefore, you need to close your position or our RMS team will close the position 5 days before expiry.
If you want to continue holding the contract, why don’t you rollover the contract to the next month?

Sorry not related to options topic but Other brokerages like Angel Brokerage, Tradejini are already allowing clients to use equity ledger as a common ledger for both Equity n commodity trading. When will Zerodha allow this? Only when NSE launches commodity contracts?

In equity options there is a concept of implied volatile, but did not found in commodity options. so please let me know whether IV is not considered for commodity option. Is there any option price calculator tool is available for commodities?

Dear Sir,
I am big fan of Zerodha Varsity, I learned a lot reading this.
I have one question on Crude Oil option expiry –

1)
Could you explain in detail what is best way to square off short call/put positions?
For example, Crude Oil SEP 5100CE may be expired worthless (Current FUT PRICE = 4956Rs); expiry date of which is 17/09/2018, Monday. Short trade was initiated on 3rd Sep’18.
When should I square off this trade if I do not want to get trapped with any extra charge?

1) I’d suggest you square off before the expiry date and not really wait for the expiry
2) I need to check on this, myself. But I guess this is the instruction to take physical delivery of the commodity, which we don’t support at Zerodha.

I agree that we should square off before expiry date.
Still, I would like to know your view on this –
For bank nifty OTM strikes, we have expiry day strategies and strategies 2 days prior to expiry (options selling) to take advantage of time decay since OTM strikes will be worthless upon expiry.
Having said that, what will you suggest me (regarding squaring off to avoid any extra charge , to avoid devolving to future position if strike price comes out to be CTM) , if I initiate trade 2 to 3 days prior to options settlement date?
Here I am aware that Options settlement date is 3 business days prior to FUT expiry date.

Q-2, From where I can download daily closing price of crude oil future for last 2 to 3 years to calculate Average and SD?

sir i wanted to know how to trade about crude oil option … suppose mega crude oil call of certain strike price is Rs.100/- then how much money is required to buy one lot crude oil call option .. what is the lot size in zerodha …

Please help me get this clarified.
If I write/sell a deep ITM Put option today [for example, 03 Dec 2018] , how does it get settled during expiry [14 Dec 2018]?
(especially when there are no buyers or sellers at that strike price)

Thank you Karthik for your time to respond to me.
I am not sure if my idea is correct but this is what I observed and hence had this question.

I speculate that the market/particular commodity is going to trend upwards.
If I write/sell a deep ITM put option, I see that I can get a large premium.
But I see that the OI is less than 10 most of the times.
Hence I wanted to understand how the exchanges would settle this during expiry (expecting that OI would be zero during expiry).

Again here, I have a question.
You have said “Anyway, the option would be exercised and settled by the exchanges.”
What do this mean?
Will it be settled as cash? If so, what would be the STT and other charges?
OR
Will it be devolved into a Future? If so, will it be in a “Buy” or “Sell” position?
Please help me understand the above.

Hey Sripathy, I’m soo sorry. I didn’t realize this was a query on commodities. The ITM option upon explicit instruction will be devolved into a future contract, which will further lead to deliveries. If you are trading with Zerodha, then its best if you square off the position before the expiry. For this reason, you need to ensure the contract you are trading with has enough liquidity.

1) What is procedure to select choice between I wish “To give EXPLICIT instruction” and ” Do not wish to give EXPLICIT Instruction” ?
Do I have a choice to Opt for it every month OR there is fixed/default setting at Zerodha?
2) What is procedure to select choice between I wish “To give CONTRARY instruction” and ” Do not wish to give CONTRARY Instruction” ?Do I have a choice to Opt for it every month OR there is fixed/default setting at Zerodha?

I mean to say what is the procedure to opt for EXPLICIT Instruction & CONTRARY Instruction as the case may be? ( This is in reference with Settlement of options mentioned in this module in para 17.3 above)

If I have Future position open & at the same time the Long Put position paired with it.
Question – If the long Put turns into ITM on expiry day of options on 15 March & I do not sell it from my end then it’ll devolved into 19 March Short Futures, right? (correct me if I’m wrong).
Here, I already have existing long Future from beginning. So in this scenario how it’ll work? It’s little tricky to understand this.

As you mentioned that “long PE devolves into short futures, but if you have a long futures position, then it would get net off. So your positions would be 0 “.
Here, I would like to know when this happens i.e on option expiry day or what?
* It’s very important to know this in advance since I already have covered position for March expiry.